Product Variety in the U.S. Yogurt Industry Dissertation Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Joseph Rossetti, M.S. Department of Economics The Ohio State University 2018 Dissertation Committee Javier Donna, Advisor Jason Blevins Bruce Weinberg Abstract My research investigates the determinants of the variety of products offered in consumer goods industries. Firms in consumer goods industries must decide which set of product lines to offer. I model this as an entry-exit decision across a set of possible product markets. Understanding how the variety of products offered by firms is determined is important due to its large impacts on consumer welfare. Also, the effect of changes in market concentration, like mergers, on product variety, depends on the specific features of the industry: the elasticity of demand, types of product differentiation available to firms, and competition from regional or niche producers.In Chapter 2 I lay out the theoretical model of product choice that I will estimate in two steps in the remaining two chapters. I provide a brief discussion of the incentives in the model for firms to introduce a new product. In Chapter 2, I estimate a model of product entry and exit in the U.S. yogurt industry from 2001-2011 using supermarket scanner data from the IRI Marketing Database. I use a two-step procedure. I first estimate yogurt industry demand and variable costs using the standard framework of Berry et al. (1995). I account for store level adoption of product lines, and brand advertising decisions in a reduced form. I also study the consumer welfare changes that have occurred in the U.S. Yogurt industry due to the adoption of several new products lines between 2001 and 2011. Previous work on changes in consumer welfare in consumer goods industries has focused on the introduction of one or two new products or brands. The U.S. Yogurt industry has seen the introduction of 16 new product lines in my sample period. In my data, controlling for price changes, the ii largest direct benefit from a new product is $3.6 million from the introduction of Greek yogurt, however, the direct benefits only account for less than 5% of the total increases in consumer welfare from new products. Price decreases after product introductions are the main source of consumer welfare gains. In Chapter 3, I estimate the fixed costs of offering a product. Estimation of the fixed cost is complicated because firms can offer any subset of the potential product lines in the industry, but I only observe in the sample a small number of the possible combinations of products. I apply the pairwise maximum score estimator of Fox (2007), which provides consistent estimates in settings with large choice sets. I use the first stage estimates to compute firms’ expected variable profits from offering alternative sets of products and choose the fixed costs parameters to maximize the number of times the model predicts that the firms’ observed choices were optimal. In a counterfactual analysis, I find that after a merger the merged firm may have a preference, depending on its fixed costs, to offer more unique products than the competitive industry, but that the incentive is not significantly stronger than the incentives already present in the competitive industry. Consumer welfare is lower after a merger regardless of the number of products. Together this leads consumers to prefer the competitive market structure since they may expect similar levels of product variety and lower prices. iii Acknowledgments I would like to thank my advisor Javier Donna, as well as the other members of my dissertation committee Jason Blevins and Bruce Weinberg, for advice and support. I would also like to thank participants of the Ohio State Department of Economics Ap- plied Microeconomics Lunch Seminar and the 44th Annual Conference of the European Association for Research in Industrial Economics for many helpful comments. Finally, I would like to thank IRI for providing access to the IRI Marketing Database. Any errors and views expressed in the paper are my own. Lastly, I would like to thank my wife Samantha for her love and support over the long process of earning a Ph.D. iv Vita Biographical Information 2009.........................................................Fayetteville High School 2013 . B.S.B.A. Economics, University of Arkansas 2013. .B.S. Mathematics, University of Arkansas 2014 . M.S. Economics, The Ohio State University Fields of Study Major Field: Economics v Table of Contents Abstract ........................................ ii Acknowledgments ................................... iv Vita ........................................... v Table of Contents ................................... vi List of Figures ..................................... viii List of Tables ..................................... ix 1 Introduction to Product Choice in Differentiated Product Markets .... 1 1.1 Introduction . 1 1.1.1 Literature Review . 3 1.2 Product Choice Game . 9 1.3 Characterization of Incremental Profits . 13 1.4 Conclusion and Preview of Chapters 2 and 3 . 18 2 Product Variety in the U.S. Yogurt Industry: Demand and Welfare .... 19 2.1 Introduction . 19 2.2 Data and Industry . 21 2.2.1 Industry and Firms . 23 2.2.2 Product Categories . 27 vi 2.3 Demand Model and Estimation . 29 2.3.1 Demand Estimation . 30 2.3.2 Variable Costs . 36 2.4 Product Variety and Welfare . 38 2.5 Conclusion . 43 3 Market Structure’s Impact on Product Choice: ............... 45 3.1 Introduction . 45 3.2 Simulating Variable Profits . 47 3.3 Fixed Cost Estimation . 50 3.4 Counterfactual Product Choice . 56 3.5 Conclusion . 59 Bibliography ...................................... 64 Appendix A: Technical Details and Data ...................... 68 1 Simulation of Nash Equilibrium Prices . 68 2 Data and Estimation Appendices . 70 2.1 Data ................................. 70 2.2 Demand Estimation Additional Specifications . 73 vii List of Figures 2.1 Share of Industry sales by quarter . 26 2.2 Welfare Effects of New Products . 41 2.3 Direct Welfare Effects of New Products . 43 3.1 Differences in Total Variable Profits for Categories of Alternatives . 62 3.2 Minimum Consumer Welfare and the Number of Products . 63 viii List of Tables 2.1 Descriptive Statistics: Demographics . 23 2.2 Descriptive Statistics: Market level variables . 24 2.3 Descriptive Statistics: Product level variables . 25 2.4 Potential Product Lines . 30 2.5 Number of Products by Brand . 31 2.6 GMM Estimates of Demand . 36 2.7 Markups and Variable Cost Descriptive Data . 38 2.8 OLS estimates of Marginal Cost model . 38 3.1 Estimates of Fixed Cost Parameter . 56 3.2 Estimates of Fixed Cost Parameter by Brand . 56 A.1 Alternative Instruments . 76 A.2 Alternative Fixed Effects........................... 77 A.3 Instrumenting for Additional Variables . 78 ix 1 Introduction to Product Choice in Differentiated Product Markets 1.1 Introduction Product variety, the number of unique products offered by firms, determines price com- petition, profitability, and consumer welfare in an industry. A firm cannot remain com- petitive without adjusting the set of products it offers to keep up with consumer taste. For example, in the U.S. Yogurt industry in 2016 Greek yogurt accounted for half of the sales of all yogurts but only accounted for 21% of General Mills yogurt sales. In response, General Mills, the owner of Yoplait, has announced in 2016 it will make adjust- ments to two-thirds of its product offerings Kell (2016). When adopting new products to match changing consumer demand, firms pay direct costs for marketing, producing, and distributing the new products, and indirect costs as consumers substitute away from existing towards the new product and competitors alter their prices. Consumers benefit from the product directly when they prefer it to existing products and indirectly when its introduction results in lower prices for competing products. In order to better un- derstand how market structure and product differentiation determine firms’ incentives to adopt products in consumer goods industries, I will estimate a model of product entry and exit in the U.S. Yogurt industry from 2001 to 2011. Firms can change the variety of products they offer in two ways1. The first way is a 1Quelch and Kenny (1994) discusses this distinction in depth terms of business strategy and I borrow 1 product line extension. Product line extensions in the yogurt industry would include: changing branding, packaging, and package size, as well as adding a new flavor (e.g. adding a strawberry low-fat yogurt where only vanilla low-fat was offered before). The second way is to adopt or introduce a new product line. Examples of product line introductions in the yogurt industry during my sample include the introduction of drink, greek, and probiotic yogurts. In addition to these new categories of yogurt, firms also adopt new combinations of existing categories. For example, after the introduction of probiotic yogurts, a firm could choose to combine probiotic yogurt with the existing category of lite (diet) yogurt to create probiotic lite yogurt. The distinction between an extension and a new product line is relevant to firms for two reasons. First, new product lines may cost more than line extensions. They require changes to production and shipping technology, and while consumers are relatively well informed about the attributes of a product line extensions, new marketing expenses may be required to inform consumers about a new product line. Second, product lines tend to be priced together. The extension may raise the value of the product line allowing a higher price to be charged, but this price will be the same across products in the line. A new product line will usually be offered at a new price point, which reflects its cost and demand by consumers for the new type of product.